The Design of Optimal Collateralized Contracts

Dan Cao () and Roger Lagunoff

Working Papers from Georgetown University, Department of Economics

Abstract: This paper presents a two-period optimal contracting model of collateral. A borrower values a capital good and a composite non-capital good. He privately observes an income shock in the composite good in the second period. Collateralization of both goods occurs in the optimal contract, whereas it does not under full information. Relative to full information, the capital good in the optimal contract is over-consumed in the initial loan period and under-consumed in the repayment period. The relation between forfeiture of assets and contractual distortion is summarized by a formula showing higher distortions associated with larger increases in forfeited collateral. Forfeiture is decreasing in income at the tails of the income distribution, and low income types forfeit more than high income types. We obtain a closed form solution in a parameterized model. Forfeited collateral is globally decreasing in income with pooling at the bottom when the borrower's initial assets are low.

Keywords: Optimal contract; asymmetric information; collateral; forfeiture; collateralized contract. (search for similar items in EconPapers)
JEL-codes: D14 D53 D82 D86 G21 G22 (search for similar items in EconPapers)
Pages: 79
Date: 2016-04-01, Revised 2017-06-01
New Economics Papers: this item is included in nep-cta and nep-mic
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